It is difficult not to be awed by the sight of the world’s biggest economy springing into life after a Covid-induced slumber, but recent estimates that earnings for S&P 500 companies could rise by an average of 33 per cent this year after a strong third quarter lends some credence to worries that all this frenetic economic activity, combined with acute constraints on supply chains, will eventually lead to a much higher inflationary environment.
There is also the unanswered question as to whether many of the earnings gains are the result of industries reporting multi-decade low inventory and stock levels. However, for the moment, at least, investors do not seem too troubled by such thoughts as the S&P 500, and other US indices, hit new record highs as the reporting season swung into gear starting with the big banks.
Impairment boost for banks
The improvement in the overall economic environment was a boon for domestic lender Wells Fargo (US:WFC), which is where the good people of almost every small- and medium-sized town in America do their banking. The release of capital held as impairment provisions continued apace with over $1.7bn (£1.2bn) of funds that had been set aside to cover potential bad debts flowing back to the income statement during the quarter. That lent the results a decidedly flattering look as the gains helped to boost several of Wells Fargo’s key numbers. For example, the return on equity rose by a scarcely credible 54 per cent to 11.1 per cent compared with the same period in 2020, largely as a result of favourable capital reserve releases.
A greyhound bus ride from Main Street over to Wall Street saw the big New York banks report similar benefits from impairment reserve releases. JP MorganChase (US:JPM) reported a $1.5bn net benefit, which made up more than 12 per cent of the net income it reported for the quarter.
However, both JPM and Wells Fargo reported a significant fall in home lending. At JPM, home loans were 18 per cent lower year on year, suggesting Americans are taking a conservative approach to their spending as the country emerges from the pandemic. Taking equity from houses is traditionally how US consumers have financed spending on big-ticket items.
The pure-play investment banks also had an interesting quarter. Goldman Sachs (US:GS.) clearly benefited from a mergers and acquisitions market that stayed buoyant for most of the quarter. Investment banking net revenues were up 88 per cent year on year to $3.7bn, with the lender raking in $1.64bn in M&A advisory fees, jumping from $507m in the same period last year. Its status as an investment bank, rather than primarily a lender and deposit taker, meant impairment reserve releases were largely immaterial to its results.
Valuations for US banks are looking rich after a much longer re-rating run than for their counterparts in the UK. The average ratio for net asset value per share, a key value metric for banks, is now running at 1.5, compared with just 0.6 in the UK.
Defensive scale is everything
Consumer durables giant Procter & Gamble (US:PG) illustrated the paradox of the earnings season so far, in that higher costs are clearly starting to affect companies’ bottom lines, but that this can be offset by the scale of a business. P&G’s operating margin took a 3.7 per cent hit during the quarter from a substantial rise in raw materials costs. However, the sheer scale of its operations meant that manufacturing efficiencies clawed back one percentage point of this, with price increases raising a further 0.5 percentage points. PG’s share price has drifted largely sideways for the past 12 months and has lagged well behind the underlying S&P 500 index. That is perhaps a measure of the difficulties that even large consumer durables companies face in passing on basic costs increases to the consumer, although this has not stopped the likes of Unilever (ULVR) from ramming through price increases.
Consumer durables groups generally face resistance to cost increases because its customers, usually supermarkets, have considerable leverage of their own when it comes to calling the shots on pricing and can negotiate down their suppliers. Still, PG’s shares currently trade at about 20 times the company’s free cash flow – similar to the peaks achieved before the financial crisis in 2007-8 – so either Americans really like their consumer durables, or a partial rotation into defensive shares could already be under way underneath the surface of the index.
Another interesting looking share is near-stablemate Johnson & Johnson (US:JNJ), which has similar defensive consumer characteristics to Procter & Gamble, with the addition of a pharmaceuticals division. Its third-quarter results showed the benefits, in specific circumstances, of being a broadly diversified conglomerate. For example, the weighting of the higher-growth pharmaceuticals business, which contributed $13bn out of $23.3bn of quarterly sales, kept the company’s results ticking along after more modest growth at both consumer health and medical devices – although apparently sales of over-the-counter pain products and respiratory medicines did well, unsurprisingly, perhaps, given the pandemic backdrop. The company also reported a large bill for litigation costs, which rose by nearly $600m to $2.1bn for the quarter, which J&J, in common with other pharma companies, tends to capitalise on the balance sheet. J&J’s PE ratio of 17 times consensus forecasts for this year is par for the course when it comes to US pharmaceutical and durable goods companies. Rather like PG, the shares haven’t had a spectacular run and are up only 6 per cent since the start of the year.
The chips are still down
The widespread shortage of semiconductors is affecting everyone from carmakers to tablet producers and has placed pressure on earnings at chip maker Intel (US:INTC). Shares in the company are down 2.8 per cent year-to-date after production capacity issues led to severe supply problems for itself and its clients all over the world. The client computing group (CCG) business segment, which powers notebooks, was the worst affected by shortages, with sales down by 2 per cent to $9.7bn. The company is guiding towards EPS for the full year of $4.50 a share, although caveated this prediction with nearly two pages of potential reasons why this may not be achieved. There doesn’t appear to be any apparent sign of the ongoing chip shortages easing, mainly as capacity in the industry takes so long to build. For example, the company has only just broken ground on two new production facilities in Chandler, Arizona, that were announced in March.
IBM (US:IBM) usually wins the annual award for company accounts most likely to carry one-off charges at any given time, and its third-quarter results did not disappoint on this point. Reported EPS took a $2.85 hit from a variety of impairments to intangible assets, retirement charges and transaction costs from the separation of infrastructure services business Kyndryl. However, the most interesting aspect was a $7bn fall in overall debt, with IBM now carrying debt of a mere $54bn. The reality is that IBM is a mature business with turnover and operating profits that have been flat for several years, which is why its current PE ratio of 14 times consensus earnings is more akin to an industry staple than a racy technology venture.
A new start for Facebook?
Few shares divide investors as much as Facebook (US:FB) after an awful quarter of bad press related to its business practices highlighted by a corporate whistleblower, and the sense that social media more generally is becoming a target for ever greater regulatory intervention. On the other hand, the share has vociferous defenders, not least investors such as Fundsmith luminary Terry Smith. Judging by the third-quarter results, it is hard not be awed by the sheer earning power of the platform. With a light capital base, the company generated sales growth of 33 per cent during the quarter, with operating margins nudging 36 per cent. For a pure growth investor, that ticks all the boxes and yet questions over its corporate culture remain.
Meanwhile, Silicon Valley’s other megalith, Alphabet (US:GOOG), parent company of Google (US:GOOGL), unveiled an astonishing 41 per cent increase in sales to $65.1bn. The company seems to be generating more cash than it can ever profitably invest, with over $142bn of cash and equivalents sitting on the balance sheet. Most notable is the consistent 15 per cent return the company makes on capital employed. Overall, it is hard to argue with the quality, but with the shares currently trading at over seven times book value, you will pay an awful lot for the privilege of owning them.
We continue our look at the US earnings season next week when investors will get the chance to see how food producers, old school car makers and Warren Buffett are getting on.
